U.K: Moves Towards Pension Reform Hit Long-Dated Gilts

By Tommy Stubbington

British Chancellor of the Exchequer George Osborne holds his Autumn budget as he leaves the Treasury to deliver his statement in the House of Commons in central London on Dec. 5, 2012.

Of all the twists and turns in George Osborne’s Autumn statement, it was the proposal to revisit a set of arcane regulations governing pension funds that made U.K. government bond investors sit up and take notice.

The chancellor’s commitment was vague and the outcome uncertain, but the move nevertheless raised the possibility that Britain could follow other European countries in adopting new accounting rules for pension schemes that could seriously dent demand for long-dated gilts, as U.K. government bonds are known.

Bonds maturing in 20 years or more fell after Wednesday’s statement, even as shorter-dated gilts rallied. They have since recouped some of those losses. Thirty-year gilt yields have risen 0.06 of a percentage point since Tuesday’s close, while 10-year yields have fallen 0.03 of a percentage point.

Some analysts have cautioned that any changes are likely to be less radical than those adopted in the Netherlands, Denmark and other countries, and weakness in long-dated gilts could be short-lived.

At issue are the formulas pension schemes use to value their assets and liabilities. Currently these are based on market valuations, meaning wild price swings can make it difficult for funds to manage their investments. A sudden drop in the value of their assets, for example, could cause gaps in pension plans, forcing the companies that run them to pump in money instead of putting funds to use in more productive areas.

Moreover, ultra-low gilt yields–which are linked to the rate at which pension schemes can discount the present value of their future liabilities–have led to a sharp rise in pension deficits.

The Department for Work and Pensions will consult on whether companies should be allowed to even out short-term swings in asset and liability values, Mr. Osborne told Parliament. The consultation will take place next year and it is unclear when recommendations will be released. Markets may have to wait a bit before some of the uncertainty is lifted.

Discussions on issuing bonds linked to consumer prices instead of retail prices have dragged on for several years pending the results of a review into how the U.K. calculates retail prices.

Such a step wouldn’t fundamentally change investor behavior, according to gilt strategists at RBS.

“Pensions’ hedging strategy should be unchanged. Smoothing for regulatory valuation purposes should not change the way investment decisions are made. These should continue to be driven by market circumstances at the time action is taken,” said Giles Gale and Simon Peck in a note to clients.

Any under-performance of long-dated gilts could be an opportunity to buy at more favorable levels, they wrote.

To be sure, gilts would not be completely immune if Mr. Osborne’s recommendations are implemented. If pension schemes get to even out their liabilities over a longer period, the urgency to buying longer-dated bonds to match their obligations to pensioners would recede.

The DWP will also examine whether regulatory considerations should include the long-term affordability of employers’ deficits.

One possible outcome is allowing pension funds to use a more favorable benchmark to calculate the value of their long-term liabilities, similar to steps taken by Dutch and Danish regulators, said Julian Wiseman, a strategist at Societe Generale.

That could remove much of the incentive for pension funds, which dominate the market for the longest-dated gilts, to buy such bonds.

“If the DWP deletes regulatory demand beyond 40 years, demand will happen only at a much higher yield,” Mr. Wiseman said.

Although such a step looks remote, uncertainty over future regulations could continue to make investors nervous.

“It is not helpful for the market to face a period of months of uncertainty about whether or not there will be a significant change in the anticipated level of regulatory-driven demand for long gilts,” said Sam Hill, an interest rate strategist at RBC Capital Markets .

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